Labor weakness drives expectations of rate cuts, and the US bond yield curve briefly ends its inversion! Friday's employment data becomes crucial

According to the Zhitong Finance and Economics APP, a key part of the U.S. Treasury yield curve briefly turned positive recently, a phenomenon that typically signals an improvement in economic prospects. Behind this shift is the market's enhanced expectation of the Federal Reserve taking more aggressive interest rate cuts, driven by the latest weaker-than-expected labor market data.

On Wednesday local time, U.S. Treasury prices rose significantly, especially for short-term bonds that are more sensitive to Federal Reserve monetary policy. This rise was against the backdrop of the U.S. job vacancies in July falling to the lowest level since early 2021. This data led to the two-year Treasury yield falling below the 10-year Treasury yield for the second time since 2022, as traders increased bets on a large-scale interest rate cut by the Federal Reserve this month.

John Fath, Managing Partner at BTG Pactual Asset Management US LLC, pointed out that the Federal Reserve may need to take action sooner, possibly even raising rates by 50 basis points. If this prediction comes true, the yield curve may experience a complete reversal.

Market participants are increasing their bets on a significant interest rate cut by the Federal Reserve at the September meeting. The interest rate swap market shows that traders have fully priced in the expectation of a 25 basis point rate cut by the Federal Reserve this month, with over 30% likelihood that the rate cut will reach 50 basis points. In addition, it is expected that the remaining three policy meetings this year will see a total cut of 110 basis points.

Wall Street economists and fund managers are closely monitoring economic data, looking for signs of weakness that could compel the Federal Reserve to start a significant rate-cutting cycle. The employment data on Wednesday indicated that the weakness in the labor market may prompt Federal Reserve officials to take action.

Earl Davis, Head of Fixed Income at BMO Global Asset Management, believes that the weakness in the labor market has lowered the threshold for the Federal Reserve to cut rates by 50 basis points later this month. He pointed out that once the Federal Reserve starts cutting rates, it is unlikely to be a one-time move, as they have enough room for rate cuts.

Yield Curve Normalizing

With traders' enhanced expectations of a Federal Reserve rate cut, the U.S. interest rate volatility index has also significantly increased. Although historically the bond yield curve tends to slope upwards, in March 2022, the yield curve inverted as the Federal Reserve embarked on its most aggressive tightening cycle in decades. However, as the Federal Reserve begins to cut rates, the yield curve may return to a normal upward trend after a prolonged period of inversion Chart 2

On Wednesday, the yield on the two-year US Treasury note significantly declined, closing at 3.754%, slightly below the ten-year Treasury yield of 3.755%. This small difference indicates that the yield curve is only showing a very mild inversion.

Although an inverted yield curve is typically seen as a precursor to an economic recession, strategists and some Federal Reserve officials have been skeptical in recent years. They believe that the recession signal sent by the inverted yield curve may be distorted due to the Fed keeping interest rates at extremely low levels.

Jerome Schneider, head of short-term bond portfolio management and funding at Pacific Investment Management Company, stated that a normal yield curve shape indicates a more normal and balanced business and monetary policy environment. Meanwhile, Bloomberg macro strategist Simon White pointed out that the unreliability of the inverted yield curve signal means it does not necessarily predict an imminent economic recession.

Priya Misra, portfolio manager at J.P. Morgan Asset Management, also believes that the inversion of the yield curve was significant on the eve of the Fed's rate cuts. She added that the extent of market pricing easing is consistent with the Fed's desire to normalize rates to maintain expectations of a soft landing for the current economy.

Federal Reserve Chairman Jerome Powell explicitly stated at the Jackson Hole symposium that he intends to prevent further cooling of the job market and believes it is time for the central bank to lower key policy rates. Market participants are awaiting the US labor report to be released on Friday, which could be a key factor in whether the Fed chooses to cut rates significantly by 50 basis points rather than a gradual 25 basis points.

Steven Zeng, US rate strategist at Deutsche Bank, stated that Friday's employment data will be the "primary factor" in determining the Fed's rate cut decision